Preparing cost estimation

PREPARING COST
ESTIMATION
Presented By,
Somashekar S M,
Asst Professor

Introduction
• Estimate costs is the process of developing an approximation of the monetary
resources needed to complete project activities.
• The key benefit of this process is that it determines the amount of cost required to
complete project work.
• Cost estimates should be reviewed and refined during the course of project to
reflect additional detail as it becomes available & assumptions are tested.
For ex: a project in the initiation phase may have rough order of magnitude
estimate in the range of +25% to +75%. Later the project has more information is
known, definitive estimates could narrow the range of accuracy -5% to +10%.
• The techniques for estimating the cost involved in performing each of the project
activities are the same as estimating the time required.
• When a project is formed under contract, care should be taken to distinguish cost
estimating from pricing.
• Cost estimating includes identifying and considering various costing alternatives.

Preparing Cost Estimation: Inputs
• Work breakdown structure: A WBS is a deliverable-oriented grouping of
project components that organizes and defines the total scope of the project;
work not in the WBS is outside of the project.
It is used to organize cost estimates and to ensure that all identified work
has been estimated.
• Resource requirements: The resource planning process is a description of
what types of resources are required and in what quantities for each element
at the lowest level of the WBS.
Resource requirements for higher levels within the WBS can be calculated
based on the lowest level values.

• Resource rates: The individual or group preparing the estimates must know
the unit rates for each resource to calculate the project costs.
If actual rates are not known, the rates themselves may have to be estimated.
• Activity duration estimates: Activity duration estimating is the process of
taking information on project scope and resources and then developing
durations for input to schedules.
It will affect cost estimates on project, where the project budget includes
allowance for the cost of financing.
• Chart of accounts: A chart of accounts describes the coding structure used
by the performing organization to financial information in its general ledger.
Project cost estimates must be assigned to the correct accounting category.

• Historical information: Information on the cost of many categories of
resources is often available from one or more of the following sources.
 Project files
 Commercial-cost estimating databases
 Project team knowledge
• Estimating publications: Commercially available data on cost estimating.
• Risks: The project team considers information on risks when procuring cost
estimates, since risks can have a significant impact on cost.
The project team considers the extent to which the effect risk is included
in the cost estimates for each activity.

Preparing Cost Estimation: Tools and Techniques
• Analogous estimating: Analogous estimating, means using the actual cost of
a previous, similar project as the basis for estimating the cost of the current
project.
It is frequently used to estimate total project costs when there is a limited
amount of detailed information about the project
Analogous estimating is generally less costly than other techniques, but it is
also generally less accurate.
It is most reliable when,
a) the previous projects are similar in fact and not just in appearance, and
b) the individuals or groups preparing the estimates have the needed
expertise.

• Parametric modelling: Parametric modelling involves using project
characteristics (parameters) in a mathematical model to predict project
costs.
Models may be simple or complex.
Both the cost and accuracy of parametric models vary widely
They are most likely to be reliable when
a) the historical information used to develop the model was accurate,
b) the parameters
c) the model is scalable

• Bottom-up estimating: It involves estimating the cost of individual
activities or work packages, then summarizing the individual estimates to get
a project total cost.
The cost and accuracy of bottom-up estimating is driven by the size and
complexity of the individual activity or work package.
• Computerized tools: Computerized tools, such as project management
software spreadsheets and simulation/statistical tools are widely used to
assist with cost estimating.
Such products can simplify the use of the tools and thereby facilitate rapid
consideration of many costing alternatives.
• Other cost estimating methods: For example, vendor bid analysis.

Preparing Cost Estimation: Outputs
• Cost estimates: Cost estimates are quantitative assessments of the likely costs of
the resources required to complete project activities. They may be presented in
summary or detail.
Costs must be estimated for all resources that will be charged to the project.
Cost estimates are generally expressed in units of currency (dollars, euros, yen
etc.) to facilitate comparisons both within and across projects.
In some cases, the estimator may use units of measure to estimate cost
Cost estimating generally include considering appropriate risk response
planning, such as contingency plans.
Cost estimated may benefit from being refined during the course of the project to
reflect the additional detail available.
The Association for the Advancement of Cost Engineering (AACE) International has
identified a progression five type estimates of construction costs during engineering
order magnitude, conceptual, preliminary, definitive, and control.

Preparing Cost Estimation: Outputs
• Supporting detail: Supporting detail for the cost estimates should include:
 A description of the scope of work estimated. This is often provided by a
reference to the WBS.
 Documentation of the basis for the estimate, i.e., how it as developed.
 Documentation of any assumptions made.
 An indication of the range of possible results; for example, Rs 10,000 ± Rs
1000 to indicate that item is expected to cost between Rs 9000 and Rs 11000.
• Cost management plan: The cost management plan describes how cost
variances will be managed.
A cost management plan may be formal or informal, highly detailed or
broadly framed, based on the needs of the project stake holders

PROJECT PROFITABILITY
EVALUATION
Presented By,
Somashekar S M
Asst Professor

Introduction
• Profit is an excess of revenues over associated expenses for an activity over a
period of time.
• Every business should earn sufficient profits to survive and grow over a long
period of time.
• Profitability means ability to make profit from all the business activities of
an organization, company, firm, or an enterprise.
• Profit refers to the total income earned by the enterprise during the specified
period of time, while profitability refers to the operating efficiency of the
enterprise.
• It shows how efficiently the management can make profit by using all the
resources available in the market.
• Profitability is an index of efficiency; and is regarded as a measure of
efficiency and management guide to greater efficiency.

Methods of profitability evaluation
1. Pay Back Period (PBP) Method
2. Average Annual Rate of Return (AARR)
3. Net Present Value (NPV)
4. Internal Rate of Return (ARR)

Payback Period
• The payback period method is concerned with the recoupment (return) of
the original investment made in a project.
• It lays emphasis on calculating the length of time it would take to recover the
original investment.
• It involves calculation of the cash flows which would arise from investment
in each year of the life of a project.
• These cash flows are accumulated year by year till the time they equal the
amount of the original investment made in the project.
• The length of time it takes to obtain the necessary cash flows equal to the
original investment, determines the payback period for the project.

• For example, if a project requires an annual investment of Rs. 25,000 crores
and is expected to generate an annual cash inflow of Rs. 5,000 crores for 10
years, the payback period can be calculated as under;
Solution: Pay Back Period (PBP) = Initial Investment/Annual, Cash Inflow
or P = C/A1
Where, P = Pay Back Period;
С = Initial Investment or the cost of capital project; and
A1 = Annual Cash Inflow
P = 25,000/5,000 = 5
Thus, the PBP of this project is 5 years

Payback Period: Acceptance/Rejectance
• PBP is used as a criterion to accept or reject an investment proposal.
• PBP calculated for a proposal is to be compared with some predetermined
target period.
• If PBP is less than the target period, the proposal may be accepted.
• If PBP is more than the target period, the proposal may be rejected.
• By this method, proposals may be ranked.
• The lower the PBP, the more profitable the projects proposal.

Average Annual Rate of Return (AARR):
• This method is based on the accounting concept of return on investment or
rate of return.
• It refers to the percentage of the annual net income earned on the average
funds invested in a project.
• The annual return of a project is the percentage of net investment in the
project.

Average Annual Rate of Return (AARR):
• Example: , if average annual return of a project is Rs. 10,000 while the initial
cost of project is Rs.1, 00, 000, the annual rate of return will be as under:
• Solution:
AARR= 10,000/1,00,000 x 100
Thus, the average rate of return is 10%.
Acceptance/Rejection: AARR is compared with the cut off or the pre-
determined rate of return. If AARR is more than the pre-determined rate of
return, the project will be accepted otherwise rejected.

Net Present Value Method (NPV)
• It is also called as present value method.
• Net present value is calculated by using an appropriate rate of interest which
is the capital cost of a firm.
• This is the minimum rate of expected return likely to be earned by the firm
on investment proposals.
• To find out the present value of cash flows expected in future periods, all the
cash outflows and cash inflows are discounted at the above rate.
• Net present value is the difference between total present value of cash
outflows and total present value of cash inflows occurring in periods over the
entire life of the project.
• When the net present value is positive, the investment proposal is profitable
and worth selecting.

• NPV = Present value of Gross Earnings – Net Cash Investment NPV can be
found out from the following formula:
NPV= A1/(1+ r)1 + A2/ (1 + r)2 + A3 (1 + r)3 + …..An/ (1+r)n – C
Where A1, A2, A3 etc. are the cash inflows at the end of first, second and third
year respectively
n = Expected life of investment proposals;
r = Rate of discount which is equal to the cost of capital;
С = Present value of costs.
• Thus, NPV = Sum of Discounted Gross Earnings – Sum of Discounted Value
of Cost

• For example, if the initial investment cost of a project is Rs.100 crores, cash inflow in
the coming years is Rs.125 crores and the market rate of interest is 10% p.a., NPV will
be as follows:
Solution: NPV = 125/ (1 + 0.10)1 – 100
= 125 x 10/11-100
= 113.64-100=13.64
• Accept or Rejectance:
The decision criterion relating to NPV may be as under:
(a) If NPV > 0, the project is profitable.
(b) If NPV < 0, the project will not be profitable.
(c) If NPV = 0, the project may or may not be started.
If the decision is to be taken between two projects, the project with high positive NPV
would be selected rather than the other

Preparing cost estimation

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